US$ Index

The risk that the Sino-US trade war morphs into an international currency war has risen

The US$ Index is up since 2010 but its only back to the middle of it range since 2000

The Chinese Yuan will weaken if the Trump administration pushes for higher tariffs

Escalation of domestic unrest in Hong Kong will see a flight to safety in the greenback

According to the US President, the Chinese are an official currency manipulator. Given that they have never relaxed their exchange controls, one must regard Trump’s statement as rhetoric or ignorance. One hopes it is the former.

Sino-US relations have now moved into a new phase, however, on August 5th, after another round of abortive trade discussions, the US Treasury officially designated China a currency manipulator too. This was the first such outburst from the US Treasury in 25 years. One has to question their motivation, as recently as last year the PBoC was intervening to stem the fall in their currency against the US$, hardly an uncharitable act towards the American people. As the Economist – The Trump administration labels China a currency manipulator – described the situation earlier this month (the emphasis is mine): –

After the Trump administration’s announcement of tariffs on August 1st added extra pressure towards devaluation, it seems that the PBOC chose to let market forces work. The policymaker most obviously intervening to push the yuan down against the dollar is Mr Trump himself.

China does not meet the IMF definition of a ‘currency manipulator’ but the US Treasury position is more nuanced. CFR – Is China Manipulating Its Currency? Explains, although they do not see much advantage to the US: –

Legally speaking, the issue of whether China meets the standard for manipulation set out in U.S. law is complex. The 2015 Trade Enforcement Act sets out three criteria a country must meet to be tagged a manipulator: a bilateral surplus with the United States, an overall current account surplus, and one-sided intervention in the foreign-exchange market to suppress the value of its currency. The Treasury Department’smost recent report [PDF] concluded that China only met the bilateral surplus criterion.

But the 1988 Omnibus Foreign Trade and Competiveness Act [PDF] has a different definition of manipulation, saying it can emerge either from action to “[impede] effective balance of payments adjustments” or action to “[gain an] unfair competitive advantage in international trade.” The United States is likely to argue that the recent depreciation was intended to give Chinese exports an edge. China would counter that it has no obligation to resist market pressures pushing the yuan down when the United States implements tariffs that hurt China’s exports.

In the past (2003-2013) China has intervened aggressively to stem the rise of its currency, since then it has intervened in the opposite direction, to the benefit of the US. Earlier this month it briefly appeared to withdrawn from the foreign exchange market, allowing the markets to set their own level based on perceptions of risk. As the Peterson Institute – Trump’s Attack on China’s Currency Policy – puts it: –

This depreciation is due to market forces: Trump’s tariffs push the dollar up against all currencies, the Chinese currency weakens as a result of the trade hit, and China will undoubtedly lower its interest rates to counter that slowdown. There is no evidence that China has sold renminbi for dollars to overtly push its exchange rate down.

Since the inflammatory pop above 7 Yuan to the US$, China has sought to calm frayed nerves, indicating that it wishes to maintain the US$ exchange rate at around current levels: nonetheless, a pre-US election sabre has been rattled.

Speculation about the next move by the Trump administration is, as always, rife, but the consensus suggests the ‘currency manipulator’ label may be used to justify an escalation of US tariffs on Chinese goods. In this new scenario, every tariff increase by the US, will precipitate a decline in the Yuan; it will be a zero-sum game, except for the US importer who will have to foot the bill for the tariffs or pass them on to the consumer. Either a weaker Yuan will mitigate their effect or the tariffs will bite, leading to either a slowdown in consumption or higher prices, or possibly both.

Barring a weaker Yuan, this sequence of events could also threaten the independence of the Federal Reserve. The central bank will be torn between the opposing policies required to meet the dual mandate of price stability and full employment. In the worst case, prices will be rise as employment falls.

Current estimates of the increased cost of tariffs to the US economy are in the region of 10%, yet during the past year the Yuan has already declined from 6.3 to 7 (11%). As the chart below shows, a move back towards 8 Yuan to the US$ cannot be ruled out, enough to significantly eclipse the impact of US tariffs to date: –

Source: Trading Economics

Conclusions and investment opportunities

In the run-up to the November 2020 presidential election, US foreign policy towards China is likely to remain confrontational. China, as always, has the ability to play the long game, although the political tensions evident in Hong Kong may highjack even their gradualist agenda. Either way, the Yuan is liable to weaken, pressurising other Asian currencies to follow suit. The US$ may appear relatively strong of late but, as the chart below shows, it is more than 50% below its 1980’s peak: –

Source: Trading Economics

A move above the 2016 highs at 103 would see the US$ Index push towards the early 2000’s highs at 120.

The US bond yield curve has been steadily inverting, a harbinger, some say, of a recession. The other interpretation is that US official rates are much too high. Relative to other developed nations US Treasury yields certainly offer value. I expect the Fed to cut rates and, if inflation rises above the 2% level, expect them to point to tariff increases as a one-off inflation effect. They will choose to target full-employment over price stability.

Barring a catastrophe in Hong Kong, followed a US military response (neither of which can be entirely ruled out) any risk-off weakening of stocks, offers a buying opportunity. Further down the road, when US 10yr bond yields turn negative, stocks will trade on significantly higher multiples.

Gold remains supported by central bank buying and fears of a US$ collapse

Gold miners look best placed to reap the benefits regardless of direction

A collapse in the U$ is needed for gold to rally substantially

In Q4 2018, as stocks declined, gold rallied 8.1% and gold mining stocks 13.7%. It was a prescient reminder of the value of gold as a portfolio diversifier. There have, however, been some other developments both for gold and gold mining stocks which are worthy of closer investigation.

Central Banks

Central bank net purchases of gold reached 651.5 tons in 2018, up 74% from 2017, when 375 tons were bought. The Russian central bank, perhaps fearing US sanctions, sold almost all of its US Treasury bonds to buy 274.3 tons of gold last year. For probably similar reasons, the Turkish central bank bought 51.5 tons, down from the 88 tons purchased the previous year. Other big central bank buyers included Kazakhstan, India, Iraq, Poland and Hungary.

In the first quarter of 2019 central banks purchased a further 145.5 tons, up 68% on Q1 2018. The trend is not new, central bank purchases have been rising since 2009: –

Source: BIS, IMF, GEMS, Reuters

Putting global reserve holdings in perspective, here is the central bank world ranking as at March 2019: –

Source: IMF, Statistica

Despite the substantial buying from central banks the price of gold has been broadly range bound for the past five years.

Source: Trading Economics

The absence of a sustained rally suggests that many investors have forsaken the barbarous relic, however, concern that the gold price will collapse have to be tempered by the cost of mining an ounce of gold. Mining costs have increased substantially since the early 2000’s due to increasingly expensive exploration costs and a general decline in ore quality. In the chart below Money Metals Exchange shows Barrick (GOLD) and Newmont (NEM) average cost of production since 2000: –

The market capitalisation of the sector has halved since 2012, leading to understandable consolidation and deleveraging. Gold, however, is an unusual commodity in that its stock is far larger than its annual production. About 3000 tons of gold is mined annually, this is dwarfed by the 190,000 tons that have been mined throughout history according to World Gold Council estimates. Since it has little industrial use, almost all the gold ever mined remains in existence: central bank reserves are a key determinant of its price. Interesting research on the subject of what drives gold prices can be found in this article from the London Bullion Market Association – Do Extraction Costs Drive Gold Prices?They conclude that, due to the large stock relative to production, the price of gold is the principal influence on the mining industry.

The US$ and inflation expectations

The rally in the gold price in 2011-2012 was linked to the Eurozone crisis, the moderation since then has coincided with a recovery in the US Dollar Index. Other factors which traditionally drive gold higher include inflation expectations, these fears have continually failed to materialise whilst the inexorable increase in debt has led some to speculate about a debt deflation spiral; an environment in which gold would not be expected to excel: –

Source: Trading Economics

A different approach to gold valuation is the ratio of the gold price to the total-return index for ten-year US government bonds. This ratio has been moving steadily higher, suggesting a shift to an era of structural inflation, according to Gavekal Research. Other evidence of inflation remains muted, however.

Is gold perfectly priced or do the central banks know something we do not?

A look back at the decade after the end of gold reserve standard is a good starting point. The Bretton Woods agreement collapsed in 1971. In the years that followed currency fluctuations were substantial and the US$ lurched steadily lower: –

Source: Trading Economics

The US$ was so little revered that in 1978 the US Treasury had to issue foreign currency denominated Carter Bonds in Swiss Francs and German Marks, such was the level of distrust in the mighty greenback.

Confidence was finally restored when Paul Volker took the helm of the Federal Reserve. Volker did what his predecessor but three, William McChesney Martin, had only talked about – taking away the punch bowl just as the party got started – he hiked interest rates and managed to subdue inflation: the fiat US$ was back in favour.

Today the US$ is undoubtedly the first reserve currency. In the era of digital money and crypto currencies the barbarous relic has stiff competition. Added to which it is traditionally an unexpected inflation hedge and traditionally affords scant protection in a deflationary environment. Given the global overhang of US$ denominated debt, many believe this is the next challenge to the international order.

…rising production in 2019, higher metals prices and lower costs could increase free cash flow by US$1.3 billion, or 19%, year over year. Companies will use this increased cash flow to lower net debt, which is expected to fall 19% year over year in 2019, placing the majors at their lowest level of leverage in five years. The majors have been focusing on returns to shareholders. Higher earnings have led to dividend payouts increasing 103% to US$2.0 billion in 2017 from US$1.0 billion in 2016 and remaining at about US$2.0 billion in 2018.

As for price of gold itself? The attractive fundamentals underpinning mining stocks is likely to cap the upside, whilst continued central bank buying will insure the downside is muzzled too. When I have little fundamental conviction I am inclined to follow the trend. A break to the upside maybe closer, but the long period of price consolidation favours a break to the downside in the event of a global crisis.

Global inflation expectations are starting to be revised downwards accordingly

Global growth, led by energy importers will be revised higher

The Oil Price

Since the summer crude oil prices have fallen sharply from above US$105 to below US$75/barrel. This price move has led to discussion of lower demand stemming from a slow-down in global economic activity. Whilst I expect a benign influence on inflation I am not convinced that the price decline is due to a reduction in global demand. Here is a daily chart for Spot West Texas Intermediate crude oil (WTI) since November 2007:-

Source: Barchart.com

The precipitous decline in 2008 was driven by the global recession following the US sub-prime crisis. The liquidity fuelled recovery in the oil price and the world economy was engineered by the largest central banks. During the same period the US$ Index rose and then declined in a broadly inverse manner to Oil though the motivation for the vacillations in the value of the US currency is broader:-

Source: Barchart.com

Aside from the steady strengthening of the US$ there are a number of factors which have conspired to drive oil prices lower. Firstly there has, and will continue to be, additional supply emanating from the US where improved energy technology has produced significant increase in production over the last five years –from 1.8bln barrels in 2008 to 2.3bln barrels in 2013. In May 2014 it hit a 25 year high of 8.4mln barrels and the Energy Information Administration (EIA) forecast 2015 production will hit the highest level since 1972. The economic impact of cheaper US energy underpins a manufacturing renaissance which is slowly gathering momentum across America.

The next factor is Saudi Arabian production which has not yet been reduced in response to lower prices. Perhaps this, in turn, is a reaction to the secular decline in oil demand from developed countries; though the announcement, last week, of an emissions reduction agreement by China and the USA may add to the downward pressure. Brookings – The U.S. and China’s Great Leap Forward opined thus: –

The world’s two largest emitters of carbon dioxide together pledged deep reductions – well in advance of the pressure they will face in the upcoming UN Climate Change negotiations that begin in Lima later this month, and which are scheduled to conclude a year from now in Paris. They also did so at a level deeper than many had expected. While both countries have already begun efforts to cut emissions, the timing of the announcement and the depth of the reductions went beyond what many diplomats, businesses and environmental groups anticipated.

… Internationally, both countries have a range of other issues to address – including working with the poorest nations which lack the resources to make similarly dramatic cuts, but who are deeply affected by a warmer, wetter world. Still, even with all those obstacles ahead, today’s agreement is the beginning of a great leap forward for climate protection.

Additional supply could swiftly come on stream from Libya. Further talks are scheduled between the rival Libyan factions in Khartoum, Sudan, on December 1st. The chart below shows how swiftly Libyan production has declined:-

Source: EIA

Also hanging over the market is the prospect of Iranian production increases as international sanctions are reduced. Between 2011 and 2013 Iranian oil exports declined from 3mln bpd to less than 1mln bpd. This year they have rebounded strongly, averaging more than 1mbpd. Iranian production has been running at around 3 mbpd but the National Iranian Oil Company expects an increase to 4.3 mbpd next year – though several commentators are doubtful of Iran’s ability to achieve this increase in output. For more detail on the Iranian situation this article – Al Monitor – Iran takes steps to reduce economic risk of falling oil prices may be of interest.

There are some demand factors which may also undermine prices. Chinese growth has been slowing but, more importantly, the Chinese administration has adopted a policy of re-balancing away from production towards domestic consumption. In theory this process should reduce China’s energy demand; off-set, to some degree, by increased export demand from other emerging market countries as they seek to supply China’s consumption needs. I believe lower energy prices will help Chinese exporters to increase margins or export volumes – or both.

Oil’s rout gained momentum in October and extended into November, with Brent at a four-year low below $80/bbl.A strong US dollar and rising US light tight oil output outweighed the impact of a Libyan supply disruption. ICE Brent was last trading at $78.50/bbl – down 30% from a June peak. NYMEX WTI was at $75.40/bbl.

Global oil supply inched up by 35 kb/d in October to 94.2 mb/d.Compared with one year ago, total supply was 2.7 mb/d higher as higher OPEC production added to non-OPEC supply growth of 1.8 mb/d. Non-OPEC production growth is forecast to ease to 1.3 mb/d for 2015 from this year’s 1.8 mb/d high.

OPEC output eased by 150 kb/d in October to 30.60 mb/d,remaining well above the group’s official 30 mb/d supply target for a sixth month running. The group’s oil ministers meet on 27 November against the backdrop of a 30% price decline since they last gathered in June.

Global oil demand estimates for 2014 and 2015 are unchanged since last month’sReport, at 92.4 mb/d and 93.6 mb/d, respectively.Projected growth will increase from a five-year annual low of 680 kb/d in 2014 to an estimated 1.1 mb/d next year as the macroeconomic backdrop is expected to improve.

OECD industry oil stocks built counter-seasonally by 12.6 mb in September.Their deficit versus average levels, after ballooning earlier this year, fell to its narrowest since April 2013. Preliminary data show that despite a 4.2 mb draw, stocks swung into a surplus to average levels in October for the first time since March 2013.

Set against these forces, driving the price of oil lower, is the geo-political tension between Russia and NATO, the ISIS insurgency in Iraq and the continued instability of the Middle East emanating from the civil war in Syria. It is difficult to estimate how far the oil price would decline if the civil unrest in Ukraine and Syria ended tomorrow, I suspect, another 20% to 25%% -during the Kuwait War in the month of October 1990 the price of WTI declined from $40 to $27/barrel even before the war was over:-

Source: Barchart.com

From a technical perspective the breakout from the 2011 range to the downside suggests support around $66, $62, $58, with a final capitulation target of $46. There are, however, reasons to be more optimistic about the prospects for oil, even near-term.

A factor, mentioned by the IEA, which may lead to a reduction in supply, is the outcome of the forthcoming OPEC meeting due to take place on 27th November. Qatar has already begun, reducing production from 800,000 bpd to 650,000bpd last month. At the end of November they will reduce production further to 500,000 bpd – in total a 40% cut. They are not the only countries to be reducing production. The tables below are taken from the OPEC Monthly Report November 2014 which included Secondary Sources: –

Source: OPEC

Whilst oil prices may trend somewhat lower the term structure of the TWI futures market has recently returned from several years of backwardation to contango – Brent Crude has been in contango for some while. This suggests that lower prices are beginning to reduce US domestic over-supply as smaller US operators cease to be able to produce oil profitably. Below $65 the EIA forecast for 2015 will probably need to be revised lower. Prices are likely to be better underpinned at their current levels.

Another encouraging factor is US domestic demand from refiners. US Crack spreads – the price spread between crude oil and its products – has started to widen in recent weeks. Oil demand should increase in response to higher product margins. The cracking margins have risen most dramatically for Gasoline but Heating Oil margins have also improved and may catch up if predictions of an exceptionally cold winter in the Northern hemisphere prove to be correct. NOAA – Winter Outlook from last month is reasonably sanguine – warm in the West and Alaska, cold in South and Rockies – but substantial snowfall in Siberia (the largest in October since 1967) is cause for caution.

Global Growth

This brings me on to the impact of lower oil prices on global growth. Obviously the large crude oil exporting countries will suffer from reduced revenue but the importers of oil – and gas, since many gas contracts are referenced to the price of oil – should be beneficiaries. This recent article from Brookings – Oil – A Question of Economics – reminds readers of some of the ubiquitous benefits to the global economy of lower energy prices: –

Virtually all businesses will benefit from lower transportation costs by expanding their profit margins or passing the benefit to consumers at lower prices. The lower income groups, who spend a higher proportion of their incomes on transport, will see their disposable incomes rise, benefiting retailers who serve their needs and thereby increasing demand in the economy. Food prices are also likely to fall, as food production, processing and sales distribution are energy intensive activities, thereby benefiting lower income groups further. Increased consumption will stimulate aggregate demand, creating investment opportunities and economic growth. Governments in the west may also have the opportunity to increase fuel taxes to cover the real cost of the negative externalities of carbon emissions, or raise revenue to improve public transportation systems. Furthermore, governments in the Middle East and Asia will reduce spending on their fuel subsidies and may take the opportunity to improve the workings of market forces, which the IMF and Western powers have been seeking for them to do.

The effect of lower oil prices is felt quite rapidly by consumers globally. Oil consumers, at the household level, receive an immediate boost to their real income. This “wind-fall” is then either spent or saved. An explanation of these effects can be found in this Gavyn Davies article in the Financial Times – Large global benefits from the 2014 oil shock (Some of you may need to subscribe to this “limited free service”). He uses IMF data to produce two very interesting charts: –

Source: IMF and Fulcrum

The fall in inflation will be of greater concern to the ECB than the other major central banks. The BoJ has already acted aggressively in response to the economic slowdown in Japan, the Abe government has deferred a scheduled tax increase and announced an early election. The Federal Reserve, having completed its tapering of QE, will be focussed on wage growth. As central bank to the world’s second largest and rising oil producer, the Fed will be concerned about the drag on growth from a slowdown in the energy and utility sectors; market expectations of interest rate increases will be deferred once again. If the ECB act aggressively to head off the chimera of deflation this may be enough to improve global confidence – I believe this makes the blue line prediction more likely. If WTI should plummet towards $60, the improvement in economic growth should be even greater.

As recently as last month the IMF – World Economic Outlook – forecast for Oil prices was $102.76 for 2014 and $99.36 for 2015. They continue to cling to their forecasts based on expectation of increased geo-political tensions. Given that their 2015 forecast is around 30% above current levels if they are mistaken and the oil price remains subdued their global growth forecast could be around 0.6% too low.

A 10% change in the oil price is associated with around a 0.2% change in global GDP, says Tom Helbling of the IMF. A price fall normally boosts GDP by shifting resources from producers to consumers, who are more likely to spend their gains than wealthy sheikhdoms. If increased supply is the driving force, the effect is likely to be bigger—as in America, where shale gas drove prices down relative to Europe and, says the IMF, boosted manufactured exports by 6% compared with the rest of the world. But if it reflects weak demand, consumers may save the windfall.

The authors go on to discuss farmers as the main direct beneficiaries of cheaper oil. India especially but other economies with a large agricultural sector as well: –

Energy is the main input into fertilisers, and in many countries farmers use huge amounts of electricity to pump water from aquifers far below, or depleted rivers far away. A dollar of farm output takes four or five times as much energy to produce as a dollar of manufactured goods, says John Baffes of the World Bank. Farmers benefit from cheaper oil. And since most of the world’s farmers are poor, cheaper oil is, on balance, good for poor countries.

Take India, home to about a third of the world’s population living on under $1.25 a day. Cheaper oil is a threefold boon. First, as in China, imports become cheaper relative to exports. Oil accounts for about a third of India’s imports, but its exports are diverse (everything from food to computing services), so they are not seeing across-the-board price declines. Second, cheaper energy moderates inflation, which has already fallen from over 10% in early 2013 to 6.5%, bringing it within the central bank’s informal target range. This should lead to lower interest rates, boosting investment.

Third, cheaper oil cuts India’s budget deficit, now 4.5% of GDP, by reducing fuel and fertiliser subsidies. These are huge: along with food subsidies, the total is 2.5 trillion rupees ($41 billion) in the year ending March 2015—14% of public spending and 2.5% of GDP. The government controls the price of diesel and compensates sellers for their losses. But, for the first time in years, sellers are making a profit. As in China, cheaper oil should reduce the pain of cutting subsidies—and on October 19th Narendra Modi, India’s prime minister, said he would finally end diesel subsidies, free diesel prices and raise natural-gas prices.

The price move has also prompted a response from the researchers at the Dallas Fed – Oil Prices Fall Despite Global Uncertainty – whilst their concern is broadly domestic they note that it is Non-OECD demand which is driving the increase in oil demand. The largest beneficiaries of lower oil prices will be oil importing emerging market countries: China, India and, to the extent that they are still considered an emerging economy, South Korea. Other candidates include Singapore, Taiwan, Poland, Greece, Indonesia, South Africa, Brazil and Turkey.

Conclusion and Investment Opportunities

Foreign Exchange

The fall in oil prices has been mirrored, inversely, by the rise of the US$. This trend is already well established but I expect it to continue. This is not so much a reflection of the strength of the US economy as the moribund nature of growth expectations in the EU and Japan.

Government Bonds

Lower inflation expectations, combined with central bank inflation targets, should ensure a delay to interest rate tightening even in response to a resurgence of wage growth. Bond prices will continue to be underpinned. At any sign of a slowing of economic growth, yield curves will flatten further. Convergence of EZ bond yields will continue.

Equities

The chart below shows the relative performance of the S&P500 Index vs MSCI Emerging Market ETF (EEM) over the last five years, after an initial rebound from the Great Recession the US stock market began to outperform other stock markets, driven by the economic boon of oil and gas technology, the implementation of TARP and the highly accommodative policies of the Fed. With the current round of QE at an end, US investors may need to look further afield in search of value :-

Source: Yahoo Finance

Expectation of “Lower for Longer” interest rates and cheaper oil is supportive for stock markets in general although there will be sector specific winners and losers. Geographically, lower oil prices will favour those economies most reliant on oil imports, especially if their exchange rate is pegged to the US$. Given the under-performance of many emerging market equities over the last few years I believe this offers the best investment opportunity going forward into 2015. Those countries with floating exchange rates such as India have already benefitted from currency devaluation of 2013; however, there is still potential upside for equities, even after the strong performance of 2014. The SENSEX Index (BSE) started the year around 21,000 and is currently making new highs at 28,000, but during the last three months it has tended to track the performance of the S&P 500 Index – despite the fall in oil prices. I anticipate a general re-rating of emerging market equities next year.